The Tightrope of Competition: How Few Companies Shape Markets and Your Choices

When only a handful of companies dominate a market, the rules of competition change dramatically. From pricing strategies to production decisions, these firms engage in a complex dance of interdependence, impacting everything from the cost of your groceries to the latest tech innovations. This article explores the fascinating world of oligopoly models, revealing how companies navigate this tightrope, and how their strategic moves shape the markets we live in.

1. The Kinked Demand Model: Why Prices Stay Put

Imagine you own a gas station in a town with only a few other gas stations. You’re trying to figure out how to set your prices. This is where the kinked demand model comes in.

• The Idea:
  • You know that if you raise your prices, your customers will likely go to the other gas stations, because they won’t raise their prices too. So, you’ll lose a lot of business.
  • On the other hand, if you lower your prices, you think the other gas stations will quickly match your price cut, to avoid losing their customers. So, you won’t gain as many customers as you hoped.
  • This creates a “kink” in your perceived demand curve. Above the current price, demand is very sensitive (elastic); below, it’s not very sensitive (inelastic).
• Picture This:
  • Think of a demand curve that looks like a bent line, with the bend at the current price.
  • If you go above the bend (raise prices), you lose a lot of customers.
  • If you go below the bend (lower prices), you don’t gain that many extra customers.
  • Also, the marginal revenue line has a vertical drop at the quantity where the kink occurs. This vertical drop allows a firms marginal cost to change, without the firm changing its profit maximizing price or quantity.
• What It Means:
  • This model helps explain why prices in oligopolies tend to be “sticky.” Firms are afraid to change prices because they think it will hurt their profits.
  • Instead of competing on price, they might focus on other things, like advertising or improving their customer service.
• The Catch:
  • This model doesn’t explain how the initial price was set in the first place. It only explains why it tends to stay the same.

2. The Dominant Firm Model: The Big Boss Sets the Rules

Sometimes, in an oligopoly, there’s one really big company that controls a large portion of the market, and then there are lots of smaller companies. This is the dominant firm model.

• The Idea:
  • The big company (the dominant firm) acts like a leader. It figures out what price will make it the most profit, and then it sets that price.
  • The smaller companies (the fringe firms) just accept that price and sell as much as they can at that price.
• How It Works:
  • The big company figures out how much demand is left after the small companies have sold all they can. This leftover demand is what the big company can sell.
  • Then, the big company sets a price that maximizes its profits, based on this leftover demand.
  • The small companies, take the price as a given.
• What It Means:
  • The big company has a lot of power in the market.
  • The small companies have to follow the big company’s lead.
• Why It Happens:
  • The big company may have lower production cost, or a much stronger brand.

3. The Cournot Model: Competing on Quantity

In this model, companies compete by deciding how much to produce.

• The Idea:
  • Imagine two companies selling the same product.
  • Each company has to decide how much to produce, but they don’t know exactly how much the other company will produce.
  • Each company makes a guess about how much the other company will produce, and then it decides how much to produce to maximize its own profit.
• How It Works:
  • Each company has a “reaction function,” which shows how much it will produce for any given amount that the other company produces.
  • The equilibrium is where the two reaction functions cross. At this point, neither company has an incentive to change its output.
• What It Means:
  • The total amount produced is more than a monopoly would produce, but less than perfect competition.
  • The more companies there are, the closer the outcome gets to perfect competition.
• Important Points:
  • The companies make their production decisions at the same time.
  • The products are the same.

4. Nash Equilibrium: Finding the Best Strategy

This is a general concept that applies to many different situations, including oligopolies.

• The Idea:
  • Imagine a game where each player has to choose a strategy.
  • A Nash equilibrium is a situation where each player has chosen the best strategy they can, given the strategies chosen by the other players.
  • In other words, no player has an incentive to change their strategy, as long as the other players keep their strategies the same.
• How It Works:
  • You look at all the possible strategies for each player.
  • You find the situation where no player can improve their outcome by changing their strategy.
• What It Means:
  • It helps predict stable outcomes in situations where players are interdependent.
  • It helps to understand strategic decision making.
• Example:
  • In the Cournot model, the Nash equilibrium is where the companies’ reaction functions cross.